* Stock volatility hits 2013 high
* Demand for E-STOXX 50 options to hedge against 5 pct fall
* Bets on stocks falling outpace bets on rises 2 to 1
By Simon Jessop and Toni Vorobyova
LONDON, Feb 27 (Reuters) - European option investors have sought protection against a further 5 percent stock market slide in the coming weeks after an Italian election that threatened political stalemate and more market uncertainty.
With no party in a strong enough position to govern alone -- and the prospect of prolonged gridlock -- the euro zone blue-chip Euro STOXX 50 index ended Tuesday down 3.1 percent, and some expect an even deeper fall.
Buyers snapped up twice as many put options -- the right to sell the index -- than calls -- the right to buy -- on Tuesday. Over 1.25 million Euro STOXX 50 put contracts traded on the Eurex exchange, more than double the Monday's volume.
Options exercisable once the index hits 2,400 and 2,500 proved the most popular put bets for March, flagging concern among investors that it could fall by 5 percent or more by the middle of next month.
"I wouldn't say option investors are necessarily panicking here, as a number of them are already hedged, but they are now wondering how far this move goes," Abhinandan Deb, head of European equity derivative research at Bank of America Merrill Lynch, said.
After hitting an 18-month high in January, euro zone blue chips had already turned lower in the run up to the Sunday-Monday vote on concern Italy may struggle to drive through the economic reforms needed to rein in its borrowing costs. The Euro STOXX 50 is down 2.4 percent so far this year.
Options on the index, made up of the 50 biggest companies in the euro zone, are the most popular method of hedging regional stock risk as they are highly liquid, allowing investors to enter and exit the trade easily.
Demand to buy protection saw the price of a March Euro STOXX 50 put exercisable at 2,400 more than triple on Tuesday.
It also pushed the Euro STOXX Volatility Index, which reflects options pricing and is a gauge of future market swings -- implied volatility, or vol for short -- to a fresh intraday 2013 high.
More could be on the way.
"Given it's a messy political situation where clarity over direction can take time to emerge, there is little rush to fade the vol spike (sell into the rally in volatility) just yet," BofAML's Deb said.
Nick Xanders, head of European equity strategy at brokerage BTIG, said the Italian election result, combined with political uncertainty in the United States around its budget battle, could see the index fall even further.
"Those who did buy puts should roll March options out into April and May, with lower strike prices, because of the continued uncertainty surrounding the Italian elections and also the U.S. sequester," he said, referring to the U.S. spending cuts due to kick in March 1, unless a new budget deal is agreed.
By "rolling" an options position, the investor's bet is carried into subsequent months rather than expiring. For April expiry, 2,200 points was the most popular put strike on Tuesday, implying a fall of some 15 percent for the E-STOXX 50.
Demand to protect directly against a further near-term fall in Italy's blue-chip FTSE MIB cash index, which led the regional fall with a drop of nearly 5 percent on Tuesday, also rose sharply, even though the contracts are not as liquid.
Ugo De Pasquale, volatility trader at Qubed Derivatives, said short-term volatility on Italian shares was up as much as 10 percent, especially on financial stocks.
"I think vols are going to stay where they are now unless the (centre-left) Democratic Party clearly signals it wants to form a great coalition, in which case they can fall back where they were before this move. I'm trying to sell a bit of long-term vol whenever I can.
Thirty-day implied volatility on the FTSE MIB jumped on Tuesday to around 33, its highest level since early August, Thomson Reuters data showed.
Longer-dated volatility saw a similar jump but held lower and with little difference between puts and calls.
Given the scale of falls in several bank shares after the election -- with Mediolanum posting its biggest one-day fall for nearly 12 years -- Italian regulators quickly banned negative bets on some stocks.
Such bets, known as "short-selling", are often used by hedge funds and involve borrowing a stock from a longer-term holder, such as a pension fund, then selling it in the hope of buying it back more cheaply later.
However, David Lewis, EMEA Head of SunGard Astec Analytics, which collates share lending data, said demand to borrow individual Italian stocks had held fairly static in recent days.
"That is an indication that investors are choosing to bet on broad country-level macroeconomic risk (through options) rather than stock specific factors," he said.
Stewart Richardson, CIO and partner at RMG Wealth Management, which manages about $100 million, said the rise in options prices showed the market was "rightly on the defensive".
"We have been cautious on European equities for a few weeks now, and we went into yesterday bearish on Europe and we continue to think bearishly," he said. "Our view is that this is part of a much bigger problem so at the moment we are sticking with June puts on Euro STOXX 50."